A traditional Individual Retirement Account (IRA) and a Roth IRA are both retirement savings accounts, but they differ in how they are taxed. Here are the key differences between a traditional IRA and a Roth IRA:
- Tax Treatment:
- Traditional IRA: Contributions to a traditional IRA may be tax-deductible, depending on your income and participation in an employer-sponsored retirement plan. This means that the amount contributed reduces your taxable income for the year of the contribution. However, when you withdraw funds from a traditional IRA during retirement, those withdrawals are taxed as ordinary income.
- Roth IRA: Contributions to a Roth IRA are made with after-tax dollars, so they are not tax-deductible. However, qualified withdrawals from a Roth IRA, including earnings, are tax-free. To be considered qualified, withdrawals must meet certain criteria, such as being taken after age 59½ and having held the account for at least five years.
- Income Eligibility:
- Traditional IRA: There are no income limits for contributing to a traditional IRA. However, the tax deductibility of contributions may be limited if you or your spouse are covered by an employer-sponsored retirement plan and your income exceeds certain thresholds.
- Roth IRA: Roth IRA contributions have income limits. These limits can vary depending on your filing status. If your income exceeds the limits, you may be ineligible to contribute directly to a Roth IRA. However, there are strategies such as a backdoor Roth IRA conversion that may allow higher-income individuals to contribute indirectly.
- Required Minimum Distributions (RMDs):
- Traditional IRA: Starting at age 72 (or age 70½ if you reached 70½ before January 1, 2020), you must begin taking Required Minimum Distributions (RMDs) from your traditional IRA. RMDs are taxable and the amount is calculated based on your age and the account balance.
- Roth IRA: Roth IRAs do not have required minimum distributions during the account owner’s lifetime. This allows the funds to potentially grow tax-free for a longer period and offers more flexibility in retirement planning.
- Early Withdrawal Penalties:
- Traditional IRA: If you withdraw funds from a traditional IRA before age 59½, you generally face a 10% early withdrawal penalty in addition to ordinary income taxes on the amount withdrawn.
- Roth IRA: Contributions to a Roth IRA can be withdrawn at any time without penalty because they were made with after-tax dollars. However, if you withdraw earnings before age 59½, you may face a 10% penalty, unless the withdrawal meets one of the exceptions.
Choosing between a traditional IRA and a Roth IRA depends on your individual circumstances, including your current and future tax situation. Factors to consider include your current tax bracket, expected tax bracket in retirement, and financial goals. It may be beneficial to consult with a financial advisor or tax professional to determine which type of IRA is more suitable for your specific needs.